Professional Documents
Culture Documents
CH 1
CH 1
Capital: What are the two basic sources of funds for all businesses?
LO 1
Solution: The two basic sources of funds for all businesses are debt and equity.
1.2
Solution: Net working capital is the difference between a firms total current assets and
its total current liabilities.
1.3
Cash flows: Explain the difference between profitable and unprofitable firms.
LO 1
Solution: A profitable firm is able to generate more than enough cash through its
productive assets to cover its operating expenses, taxes, and payments to
creditors. Unprofitable firms fail to do this, and therefore they may be forced
to declare bankruptcy.
1.4
Management role: What are the three major decisions that most concern
financial managers?
LO 1
Solution: Financial managers are most concerned with the capital budgeting decision,
the financing decision, and the working capital decision.
1.5
Cash flows: What is the general decision rule for a firm considering undertaking
a project? Give a real-life example.
LO 1
Solution: A firm should undertake a capital project only if the value of its future cash
flows exceeds the cost of the project.
1.6
Solution: Capital structure shows how a company is financed; it is the mix of debt and
equity on the liability side of the balance sheet. It is important as it affects the
risk and the value of the company. In general, companies with higher debt-toequity proportions are riskier because debt comes with legal obligations to pay
periodic payments to creditors and to repay the principal at the end.
1.7
Management role: What is working capital management, and what are some of
the working capital decisions that a financial manager faces?
LO 1
Solution: The three forms of business organization discussed are sole proprietorship,
partnership, and corporation.
1.9
Solution: Advantages:
Owners keep all the profits and do not have to share the decision-making
authority with anyone.
Disadvantages:
The proprietor has an unlimited liability for all business debt and financial
obligations of the firm.
The amount of capital that can be invested in the firm is limited by the
proprietors wealth.
1.10
limited partners are only responsible for business obligations up to the amount
of capital they contributed to the partnership.
1.11
Organizational form: Who are the owners in a corporation, and how is their
ownership represented?
LO 3
Solution: The owners of a corporation are its stockholders or shareholders, and the
evidence of their ownership is represented by shares of common stock. Other
types of ownership do exist and include preferred stock.
1.12
Solution: Limited Liability for a stockholder means that the stockholders legal liability
extends only to the capital contributed or the amount invested.
1.13
Solution: Most lawyers, accountants, and doctors form what are known as limited
liability partnerships. These formations combine the tax advantages of
partnerships with the limited liability of corporations.
1.15
Solution: The board of directors of a corporation is responsible for serving the interests
of stockholders in managing the corporation. It is possible that the interest of
managers may deviate from those of the stockholders. The boards objective is
to monitor and correct any management decisions that might not be in the best
interest of the stockholders. For example, board duties include hiring and
firing the CEO, setting CEO pay, and monitoring the investment decisions of
managers.
1.16
Finance function: All public companies must hire a certified public accounting
firm to perform an independent audit of their financial statements. What exactly
does an audit mean?
LO 3
Solution: An independent CPA firm that performs an audit of a firm ensures that the
financial numbers are reasonably accurate, that accounting principles have
been adhered to year after year and not in a manner that distorts the firms
performance, and that the accounting principles used are in accordance with
generally accepted accounting principles (GAAP).
1.17
Firms goal: What are some of the drawbacks to setting profit maximization as
the main goal of a company?
LO 4
Solution:
It does not address the size and timing of cash flowsit does not account
for the time value of money.
1.18
Firms goal: What is the appropriate goal of financial managers? Can managers
decisions affect this goal in any way? If so, how?
LO 4
Solution: The appropriate goal of financial managers should be to maximize the current
value of the firms stock price. Managers decisions affect the stock price in
many ways as the value of the stock is determined by the future cash flows the
firm can generate. Managers can affect the cash flows by, for example,
selecting what products or services to produce, what type of assets to
purchase, or what advertising campaign to undertake.
1.19
Firms goal: What are the major factors that affect a firms stock price?
LO 4
Solution: The factors affecting the stock price include: the characteristics of the firm,
the economy, economic shocks, the business environment, expected cash
flows, and current market conditions.
1.20
Solution: Agency relationships develop when a principal hires an agent to perform some
service or represent the firm. An agency conflict arises when the agents
interests and behaviors are at odds with those of the principal. Agency
conflicts can be reduced through the following three mechanisms:
management compensation, control of the firm, and the board of directors.
1.21
Firms goal: What starts to happen when if a firm is poorly managed and its stock
price falls substantially below its maximum?
LO 4
Solution: If the stock price falls below its maximum potential price, it attracts corporate
raiders, who look for fundamentally sound but poorly managed companies
they can buy, turn around, and sell for a handsome profit.
1.22
Business ethics: How can a lack of business ethics negatively affect the
performance of an economy? Give an example.
LO 6
Solution: A lack of business ethics can lead to corruption, which, in turn, creates
inefficiencies in an economy, inhibits the growth of capital markets, and slows
the rate of overall economic growth. For example, the Russian economy has
had a relatively difficult time attracting foreign investment since the fall of the
Soviet Union due, in part, weak ethics in the business community and
corruption in the business community and local and national governments.
Lower foreign investment has led to slower overall economic growth than the
country might otherwise have enjoyed.
1.24
Agency conflicts: What are some possible ways to resolve a conflict of interest?
LO 5
Solution: Insider trading is an example of information asymmetry. The main idea is that
investment decisions should be made on an even playing field. Insider trading
is morally wrong and has also been made illegal.